Defence stocks have outpaced the global market this year by the most in almost a decade, on expectations of higher military spending by western governments and as ethically minded investors re-evaluate the sector.

An MSCI index tracking aerospace and defence shares has beaten a broader gauge of worldwide equities by 17 percentage points in dollar terms since early January. Such outperformance has occurred only two other times since 1999.

Russia’s invasion of Ukraine on February 24 has fuelled expectations of new government orders, higher revenues and stronger profits for companies in the defence sector. Analysts say the war has changed investors’ view of the industry, underscoring its role in facilitating international security.

In turn, shares of companies such as Lockheed Martin and the UK’s BAE Systems have rallied strongly, with FTSE 100-listed BAE alone up more than a third year-to-date. Supporting those gains, Vladimir Putin’s incursion of his neighbouring country has reignited a debate about the extent to which manufacturers of weapons and defence machinery should be excluded from environmental, social and governance focused portfolios.

Yet some have warned of premature enthusiasm over defence stocks, arguing that it is still too early to say when the promises of bigger budgets will translate into beefed-up bottom lines.

“There seems to be the beginning of some irrational exuberance about the industry. It is really too early to tell,” said Bill Greenwalt, who served as deputy under-secretary of defence for industrial policy during the George W Bush administration and is now with the American Enterprise Institute.

The US, UK and other allies have pledged significant sums in military assistance to Ukraine and sent hundreds of anti-tank missiles, drones, ammunition and other weapons to the country. The US alone has offered more than $3bn, including a new $800mn aid package announced on Thursday that will include heavy artillery and tens of thousands of rounds of ammunition.

Most of the weapons so far, however, have come from existing government stockpiles. “We have not yet seen an increase in orders and contracts or a recognition of the need to act quickly,” said Greenwalt.

Doug Harned, analyst at Bernstein, points out that the surge in stock prices is consistent with trends seen in previous regional conflicts. The gains have generally been given back, often within six months. Investors, he adds, need to think about the underlying budget trends. “Do the budget trends and relative valuations make defence interesting as a long-term play?”

Others point out that the timescales in the industry mean any orders, if they do come through, will take time to feed through to companies’ bottom lines.

“If you put something into the budget this year, a tank or an aircraft or naval vessel, it won’t be delivered until 2023, 24, 26 in some instances. You see the moves in these stocks and in the sentiment but . . . managements are a little reticent to frame what all these mean for their companies,” said Byron Callan of research group Capital Alpha Partners.

Jim Taiclet, chief executive of US defence giant Lockheed Martin, was cautious earlier this week. The head of the company — which together with Raytheon makes the Javelin anti-tank missiles that have been sent to Ukraine — acknowledged that the more challenging environment suggested that “deterrence is a more valuable product than it’s ever been”. But he stressed that it was “too early” to say if and when this would translate into actual contracts. The company did not upgrade its outlook for 2022.

For long-term investors, then, the biggest question is whether western governments’ promises to spend more on defence will result in a permanent shift. Weapons programmes had previously come under pressure from competing demands on government finances, in particular health projects during the Covid-19 pandemic.

Some major investors had gone so far as to bet against major defence contractors before the invasion.

But defence has moved back up the list of priorities in 2022, in a scenario epitomised by Germany. Berlin has announced a historic shift in defence policy and said it would launch a €100bn fund to modernise its armed forces. In turn, shares in Germany’s listed defence contractors have soared. The market value of Rheinmetall, which makes tanks and armoured vehicles for Nato countries, has more than doubled this year.

BlackRock, which held a 0.6 per cent short position in BAE Systems at the end of January, rapidly cut back its position by a third in the second half of February, according to data from Breakout Point.

Citadel Europe also reduced its short of Italy’s Leonardo from 0.69 per cent to 0.42 per cent on February 10, while BlackRock UK cut back its sizeable 1.13 per cent short position in the Italian arms manufacturer to 0.12 per on February 28. Hedge funds Sandbar and Egerton also cut back short positions in Leonardo in the second half of February.

‘Big dilemma’ for ESG investors

While increased western defence budgets have yet to be locked in following the invasion, some suggest the conflict may still spark a shift in sentiment among ESG investors. Industry executives had, in recent months, become increasingly concerned that the sweeping trend for sustainability-focused investment would lead to their shares being shunned by institutional investors.

“Perhaps the biggest change that could result from the invasion of Ukraine is a reversal of the lazy ESG view that defence is ‘bad’,” said Robert Stallard, analyst at Vertical Research Partners.

“The big dilemma is that a lot of sustainable funds would have completely had exclusions on defence spending [including] government contracts, all that sort of stuff,” said Gavin Rochussen, chief executive of Polar Capital.

Russia’s invasion of its neighbour has since muddied the waters. “How do you treat protecting a country from a foreign invader? Is it right that you don’t actually support countries spending on defending themselves?” he added.

SEB Investment Management, the fund management arm of the Swedish bank with SKr831bn under management, is one of the few to have explicitly loosened its policies on excluding defence stocks. As of the beginning of April, some of its funds will now be able to invest in the industry.

The change, however, only goes so far — just six out of SEB’s more than 100 funds will be able to make these investments, and companies that violate international conventions on weapons such as landmines and cluster bombs will still be excluded, as will producers of nuclear weapons.

“It is important to remember that many of our customers and unit-holders still do not want to and cannot invest in the defence industry, and that going forward, many of SEB Investment Management’s funds therefore will continue to exclude such investments,” SEB said.

Other policy changes, if they come, will take time. A recent survey of investors by analysts at Jefferies found that while there appeared to be a call for a less stringent approach towards defence stocks, few investors had actually implemented changes to their policies. According to the survey, 44 per cent of respondents were currently revisiting their policies on ESG, but just 8 per cent were doing so specifically on defence.

Still, Philip Saunders, fund manager at Ninety One, is confident that change is on the way. “The pendulum is swinging. This is a moment where it looked like momentum was in one direction, and now we need to step back collectively, because the reality is the real world is a lot nastier than we thought before February 24,” he said.